GROUP PROJECT: GLOBAL FINANCIAL

CRISIS
A financial crisis is any of a range of situations in which financial assets suddenly lose a
large part of their nominal value causing problems like bank panics, recessions coinciding with
these panics, stock market crashes and the bursting of market bubbles, currency crises and
sovereign defaults. The financial crisis of 2007/2008 is considered the largest and most severe
financial event since the World War II (Claessens et al., 2003). It was mainly precipitated by the
bursting of the bubble in the subprime mortgage market, leading to a high default rate in
mortgages.

The primary causes of the Global Financial Crisis (also known as the financial crisis
of 2007-8)

The global financial sub-prime crisis of 2007-08 was primarily caused by deregulation in
the financial industry that permitted banks to engage in hedge fund trading with derivatives. The
Gramm-Leach-Bliley Act repealed the Glass-Steagall Act of 1933, allowing banks to use bank
deposits to trade in derivatives. Mortgages were bundled into mortgage backed securities and
sold to investors, who took all the risk of default. These securities were rated mostly as
investment grade by rating agencies, who failed to properly rate such high-risk securities. To limit
the default risk, investors would take insurance on these securities called credit default swaps.
As demand for these mortgage-backed securities rose, and since they were not bearing the
default risk, banks started giving mortgages to just about anyone (subprime lending) so as to cash
in on the derivatives from them.

Many homeowners who didn’t qualify because of their poor credit history were allowed
to take out loans for 100 per cent or more of the value of their new homes (Amadeo, 2018). This
led to an increase in demand for housing and house prices leading to the housing bubble. When
the bubble burst due to increase in interest rates and massive defaults on mortgages and
subsequent crash of house prices, investors found themselves with derivatives that could not be
repaid with sale of the houses which backed them and that the insurance companies could not
cover the credit default swaps they had sold.

This led to rapid devaluation of mortgage-backed securities and credit default swaps and
other related financial instruments and buyers for them disappeared leading to a liquidity crisis
in the banks invested in these securities. Some of the banks affected declared bankruptcy while
others were acquired and got bailouts from the government to avert the crisis which had spilled
over into the whole economy.

The market features and conditions that constitute a financial crisis in general.

There are a number of characteristics of a financial crisis. It can manifest itself through
banking crises through bank runs; through speculative asset bubbles and/or crashes; or through
 GROUP PROJECT: GLOBAL FINANCIAL
CRISIS
currency crises, which can be systemic causing many institutions and corresponding assets to
behave in an unsustainable manner.
The markets usually are gripped in panic during times of crises. Asset prices come crashing
down and may lead to panic withdrawals causing bank runs in extreme cases; liquidity in the
system freezes up, as people are afraid of lending to each other or institutions and economy goes
into long recession.

The primary causes of the Global Financial Crisis and how they led to the features
of a financial crisis

The financial crisis in 2007/08 had many factors which were also common to the previous
crises. These were mainly: the rapid asset price increases that ended up bursting; credit booms
that led to excessive debt burdens; dramatic expansion in marginal loans and systemic risk; and
the failure of regulation and supervision to keep up with the developments ahead of the crisis
(Claessens et al., 2013). The real estate burst, caused by failure by many to pay for houses due to
interest rate rises and the subsequent house price fall, led to a sudden crash of the value of
mortgage backed securities. The market in those securities vanished leading to a liquidity crunch
and collapse of many banks in the ensuing crisis.

The response of policymakers and regulators to the global financial crisis

• Dodd-Frank Act was enacted to overcome the challenges faced during 2007 financial
crisis.
• Also, prior to financial crisis the committee implemented regulations knows as Basel I
and Basel II.
• After the crisis, they implemented as Basel II.5 which increases the capital for market
risk
• Increased focus by regulators on risk management and stress testing in banks

The intended effects of the policymakers’ and regulators’ responses

The intended effects of the policies and reforms were to be able to enhance consumer
protection and safety of taxpayer’s money. There had been fewer restrictions on the bank
before the financial crisis and so one of the main goals was to subject banks to more stringent
resolutions. The aim of the Dodd-Frank Act was to eliminate the need for future taxpayer-
funded bailouts making the capital requirements a larger amount with a close watch of the
government for any disaster.
 GROUP PROJECT: GLOBAL FINANCIAL
CRISIS
The downsides and unintended consequences that can occur when applying
regulation and policy to the financial markets
Some of the unintended consequences is that some of the rules remain unwritten and
still await approval, also it was expected that the big banks would have induced regulatory
rollbacks by now which has not happened yet.
One of the big consequences of Dodd-Frank act is that Volcker Rule already pushed
several major banking functions into the shadow banking system and appear to retrenching
from market making and trading for clients which can cause liquidity issues especially in bonds
market. As more and more activity increases into shadow banking, proprietary trading becomes
less regulated defeating the intentions of Volcker Rule.

The features of financial markets which often need regulation

The features which often need regulation include financial institutions which need
prudential regulation that requires banks to hold a certain percentage of capital as reserves.
Investment products also require regulation to protect the consumer by clearly stating the risk,
fees and terms and conditions of these products. The financial market players also need
regulation to ensure they are solvent and ensure the stability of the markets and fairness,
efficiency and transparency in the markets. Competition is another feature that needs regulation
to help drive prices down, spur innovation and prevent collusion among big market players.

Reference:
Goodwin K. Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.
Claessens, S., Kose, M., Laeven, L. and Valencia, F. (2013). Financial crises. Washington, DC: IMF.
Singh, M. (2018). The 2007-08 Financial Crisis in Review. [online] Investopedia.
https://publicpolicy.wharton.upenn.edu/issue-brief/v3n10.php
https://en.wikipedia.org/wiki/Regulatory_responses_to_the_subprime_crisis
https://www.cbpp.org/research/economy/the-financial-crisis-lessons-for-the-next-one
James Crotty. Structural causes of the global financial crisis: a critical assessment of the ‘new financial
architecture’ (Cambridge Journal of Economics, Volume 33, Issue 4)